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A Hidden Markov Approach To The Forward Premium Puzzle

Author

Listed:
  • ROBERT J. ELLIOTT

    (Haskayne School of Business, University of Calgary, 2500 University Drive NW, Calgary, Alberta, T2N 1N4, Canada)

  • BING HAN

    (Orfalea College of Business, California Polytechnic State University, San Luis Obispo, California, USA)

Abstract

A Hidden Markov Chain (HMC) is applied to study the forward premium puzzle. The weekly quotient of the interest rate differential divided by the log exchange rate change is modeled as a Hidden Markov process. Compared with existing standard approaches, the Hidden Markov approach allows a detailed analysis of the puzzle on a day-to-day basis while taking into full account the presence of noise in the observations. Two and three state models are investigated. A three-state HMC model performs better than two-state models. Application of the three-state model reveals that the above quotient is mostly zero, and hence leads to the rejection of the uncovered interest rate parity hypothesis.

Suggested Citation

  • Robert J. Elliott & Bing Han, 2006. "A Hidden Markov Approach To The Forward Premium Puzzle," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 9(07), pages 1009-1020.
    • Handle: RePEc:wsi:ijtafx:v:09:y:2006:i:07:n:s0219024906003949
    DOI: 10.1142/S0219024906003949
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    Cited by:

    1. Rob Hayward & Jens Hölscher, 2017. "The Forward-Discount Puzzle in Central and Eastern Europe," Comparative Economic Studies, Palgrave Macmillan;Association for Comparative Economic Studies, vol. 59(4), pages 472-497, December.

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